Re-cap – bid/offer spreads

Prices on forex currency pairs are quoted as bid/offer spreads. the bid being the sell price and the offer being the buy price. So, if the EUR/USD is quoted at 1.4256/1.4258, a trader wanting to go long (buy) would buy the currency pair at 1.4258, while a trader wanting to go short (sell) would sell the currency pair at 1.4256.

The difference between the two prices, in this case, is two pips, or 0.0002 (a pip is usually measured as 0.0001).

Typically, the more liquid a forex pair is, the smaller the bid/offer spread will be. The liquidity of a pair is determined by how many trades are taking place on it, so the most commonly traded pairs, such as the EUR/USD, GBP/USD, AUD/USD and USD/CHF, are the most liquid, and generally have the smallest bid-offer spreads.

Forex is a market on which traders can trade commission-free. This means that forex providers make their profits on the differences between the bid and offer prices that they charge for trading on currency pairs.

In the case of the EUR/USD pair quoted at 1.4256/1.4258, a trader going long would buy the pair at 1.4258. The pair, now valued at 1.4256 in the market, would have to rise three pips for the trader to make a profit – one pip to 1.4257, a second pip to 1.4258 (the break-even point), and a third pip to 1.4259. The two-pip movement in which the trader breaks even is where the forex provider makes its profit.

What is price shading?

Forex providers usually add pips to the prices quoted to them by the banks to increase their profit margin. If the inter-bank rate for the EUR/USD pair was 1.4255/1.4256, the provider might quote it to customers as 1.4254/1.4257, adding one pip to either side.

Price shading is when a forex provider, believing that a particular currency is going to move in a certain direction, will add pips to one side of the currency quote. So if a forex provider believed the EUR/USD pair would rise, it might quote the pair at 1.4256/1.4260, rather than 1.4256/1.4258, meaning that a trader going long would have to buy the pair at 1.4260.

Consequently, the currency pair would have to move five pips for the trader to make a profit, and the four-pip movement in which the trader broke even would be the forex provider’s profit.

Generally, if there are more buyers than sellers of a currency pair, a provider will shade the buy side by adding pips to the offer price. Likewise, if there are more sellers than buyers of a currency pair, a provider will shade the sell side by adding pips to the bid price.

Why it works

If there were 500 buyers and 500 sellers of a certain currency pair, and the forex provider had added one pip to either side of the inter-bank quote, the provider would make one pip for every trade (or 1,000 pips).

If there were 300 buyers and 700 sellers, the provider would add two pips to the bid price and no pips to the offer price.

So the inter-bank rate for the EUR/USD pair is 1.4255/1.4256 and the broker quotes it at 1.4253/1.4256, meaning the sellers sell at 1.4253 while the buyers buy at 1.4256. As the number of sellers in the market is higher than the number of buyers, the currency pair falls in value. The pair needs to fall by two pips for the sellers to break even (from 1.4255 to 1.4253), and the forex provider makes those two pips in profit. That is 1,400 pips of profit for 1,000 traders.

How to use this to your advantage

To determine whether your forex provider is using price shading you would need to compare the quoted prices to those quoted by Reuters or Bloomberg, or open an account with two providers, one of them being a straight-through processing broker who will charge a commission rather than profit on the bid/offer spread.

If your provider’s prices are consistently biased to one side, it means that the majority of orders coming from retail customers are coming from that side. Because the majority of retail traders are usually wrong, you could trade on the opposite side – if the bias is on the buy side, you could sell, and if the bias is on the sell side you could buy.

Also, as these spreads disadvantage the majority by cutting into their profits (remember, your currency pair needs to cross the bid/offer spread to break even before you can make a profit), you will benefit from not losing the shaded pips, essentially entering your position at a better price than the majority of traders.

Any provider that doesn’t charge a commission for forex trading will make its profit in the bid/offer spread; and it is a trader’s responsibility to research different forex providers to understand their commission structures and how they make a profit.

A trader should choose a reputable provider based on the strength of the company, their history of service, any awards they have won and whether they are regulated by your country’s regulatory authority. A good forex provider will offer this information freely, along with transparent information about their spreads, accessible online, by email or by calling a customer service representative.

As forex spreads can vary due to the levels of liquidity in the market, a good forex provider should pass narrow spreads in the underlying market on to clients, as well as having a maximum spread cap.